Not Just One Man - Barings
   I. How Leeson Broke Barings
   II. Lessons from Leeson


Not Just One Man - Barings

I. How Leeson Broke Barings

The activities of Nick Leeson on the Japanese and Singapore futures exchanges, which led to the downfall of his employer, Barings, are well-documented. The main points are recounted here to serve as a backdrop to the main topic of this chapter - the policies, procedures and systems necessary for the prudent management of derivative activities.

Barings collapsed because it could not meet the enormous trading obligations, which Leeson established in the name of the bank. When it went into receivership on February 27, 1995, Barings, via Leeson, had outstanding notional futures positions on Japanese equities and interest rates of US$27 billion: US$7 billion on the Nikkei 225 equity contract and US$20 billion on Japanese government bond (JGB) and Euroyen contracts. Leeson also sold 70, 892 Nikkei put and call options with a nominal value of $6.68 billion. The nominal size of these positions is breathtaking; their enormity is all the more astounding when compared with the banks reported capital of about $615 million.

The size of the positions can also be underlined by the fact that in January and February 1995, Barings Tokyo and London transferred US$835 million to its Singapore office to enable the latter the meet its margin obligations on the Singapore International Monetary Exchange (SIMEX).

Reported activities (Fantasy)

The build-up of the Nikkei positions took off after the Kobe earthquake of January 17. This is reflected in Figure 10.1 - the chart shows that Lesson's positions went in the opposite direction to the Nikkei - as the Japanese stock market fell, Leeson's position increased. Before the Kobe earthquake, with the Nikkei trading in a range of 19,000 to 19,500, Leeson had long futures positions of approximately 3,000 contracts on the Osaka Stock Exchange. (The equivalent number of contracts on the Singapore International Monetary Exchange is 6000 because SIMEX contracts are half the size of the OSE.) A few days after the earthquake Leeson started an aggressive buying programme which culminated in a high of 19,094 contracts reached about a month later on February 17.

Figure 10.1 Baring's Long Positions against the Nikkei 225 Average.
Source: Datastream and Osaka Securities Exchanges

But Leeson's Osaka position, which was public knowledge since the OSE publishes weekly data, reflected only half of his sanctioned trades. If Leeson was long on the OSE, he had to be short twice the number of contracts on SIMEX. Why? Because Leeson's official trading strategy was to take advantage of temporary price differences between the SIMEX and OSE Nikkei 225 contracts. This arbitrage, which Barings called 'switching', required Leeson to buy the cheaper contract and to sell simultaneously the more expensive one, reversing the trade when the price difference had narrowed or disappeared. This kind of arbitrage activity has little market risk because positions are always matched.

But Leeson was not short on SIMEX, infact he was long approximately the number of contracts he was supposed to be short. These were unauthorised trades which he hid in an account named Error Account 88888. He also used this account to execute all his unauthorised trades in Japanese Government Bond and Euroyen futures and Nikkei 225 options: together these trades were so large that they ultimately broke Barings. Table 10.1 gives a snapshot of Leeson's unauthorised trades versus the trades that he reported.

For the rest of the chapter, contracts will be discussed or converted into SIMEX contract sizes.

Unreported positions (Fact)

The most striking point of Table 10.1 is the fact that Leeson sold 70,892 Nikkei 225 options worth about $7 billion without the knowledge of Barings London. His activity peaked in November and December 1994 when in those two months alone,

Table 10.1 Fantasy versus Fact: Leeson's Positions as at End February 1995.
  Number of contracts1
nominal value in US$ amounts
Actual position in terms of open interest of relevant contract2
  Reported3 Actual4
Nikkei 225 30112
$2809 million
long 61039
$7000 million
49% of March 1995 contract and 24% of June 1995 contract.
JGB 15940
$8980 million
short 28034
$19650 million
85% of March 1995 contract and 88% of June 1995 contract.
Euroyen 601
$26.5 million
short 6845
$350 million
5% of June 1995 contract, 1% of September 1995 contract and 1% of December 1995 contract.
Nikkei 225 Nil 37925 calls
$3580 million
32967 puts
$3100 million
1. Expressed in terms of SIMEX contract sizes which are half the size of those of the OSE and the TSE. For Euroyen, SIMEX and TIFFE contracts are of similar size.
2. Open interest figures for each contract month of each listed contract. For the Nikkei 225, JGB and Euroyen contracts, the contract months are March, June, September and December.
3. Leeson's reported futures positions were supposedly matched because they were part of Barings' switching activity, i.e. the number of contracts on either the Osaka Stock Exchange, the Singapore International Monetary Exchange or the Tokyo Stock Exchange.
4. The actual positions refer to those unauthorized trades held in error account '8888'.

Source: The Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, Her Majesty's Stationery Office, 1995

he sold 34, 400 options. In industry parlance, Leeson sold straddles. i.e. he sold put and call options with the same strikes and maturities. Leeson earned premium income from selling well over 37,000 straddles over a fourteen month period. Such trades are very profitable provided the Nikkei 225 is trading at the options' strike on expiry date since both the puts and calls would expire worthless. The seller then enjoys the full premium earned from selling the options. (see Fig 10.2 for a graphical presentation of the profit and loss profile of a straddle.) If the Nikkei is trading near the options' strike on expiry, it could still be profitable because the earned premium more than offsets the small loss experienced on either the call (if the Tokyo market had risen) or the put (if the Nikkei had fallen.).

Figure 10.2 Payoff Profile of a Straddle.

The strike prices of most of Leeson's straddle positions ranged from 18,500 to 20,000. He thus needed the Nikkei 225 to continue to trade in its pre-Kobe earthquake range of 19,000 - 20,000 if he was to make money on his option trades. The Kobe earthquake shattered Leeson's options strategy. On the day of the quake, January 17, the Nikkei 225 was at 19,350. It ended that week slightly lower at 18,950 so Leeson's straddle positions were starting to look shaky. The call options Leeson had sold were beginning to look worthless but the put options would become very valuable to their buyers if the Nikkei continued to decline. Leeson's losses on these puts were unlimited and totally dependent on the level of the Nikkei at expiry, while the profits on the calls were limited to the premium earned.

This point is key to understanding Leeson's actions because prior to the Kobe earthquake, his unauthorised book, i.e. account '88888&' showed a flat position in Nikkei 225 futures. Yet on Friday 20 January, three days after the earthquake, Leeson bought 10,814 March 1995 contracts. No one is sure whether he bought these contracts because he thought the market had over-reacted to the Kobe shock or because he wanted to shore up the Nikkei to protect the long position which arose from the option straddles. (Leeson did not hedge his option positions prior to the earthquake and his Nikkei 225 futures purchases after the quake cannot be construed as part of a belated hedging programme since he should have been selling rather than buying.)

When the Nikkei dropped 1000 points to 17,950 on Monday January 23, 1995, Leeson found himself showing losses on his two-day old long futures position and facing unlimited damage from selling put options. There was no turning back. Leeson, tried single-handedly to reverse the negative post-Kobe sentiment that swamped the Japanese stock market. On 27 January, account '88888' showed a long position of 27,158 March 1995 contracts. Over the next three weeks, Leeson doubled this long position to reach a high on 22nd February of 55,206 March 1995 contracts and 5640 June 1995 contracts.

The large falls in Japanese equities, post-earthquake, also made the market more volatile. This did not help Leeson's short option position either - a seller of options wants volatility to decline so that the value of the options decrease. With volatility on the rise, Leeson's short options would have shown losses even if the Tokyo stock market had not plunged.

Leeson engaged in unauthorised activities almost as soon as he started trading in Singapore in 1992. He took proprietary positions on SIMEX on both futures and options contracts. (His mandate from London allowed him to take positions only if they were part of 'switching' and to execute client orders. He was never allowed to sell options.) Leeson lost money from his unauthorised trades almost from day one. Yet he was perceived in London as the wonder boy and turbo-arbitrageur who single-handedly contributed to half of Barings Singapore's 1993 profits and half of the entire firm's 1994 profits. The wide gap between fact and fantasy is illustrated in table 10.2 which not only shows the magnitude of Leeson's recent losses but the fact that he always lost money. In 1994 alone, Leeson lost Barings US$296 million; his bosses thought he made them US$46 million, so they proposed paying him a bonus of US$720,000.

Table 10.2 Facts versus Fantasy: Profitability of Leeson's Trading Activities.
Period Reported (million) Actual (million) Cumulative actual1 (million)
1 Jan 1993 to 31 Dec 1993 +GBP 8.83 -GBP 21 -GBP 23
1 Jan 1994 to 31 Dec 1994 +GBP 28.529 -GBP 185 -GBP 208
1 Jan 1995 to 31 Dec 1995 +GBP 18.567 -GBP 619 -GBP 827
1. The cumulative actual represents Leeson's cumulative losses carried forward.
Source: Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, Her Majesty's Stationery Office, 1995.

The cross-trade

How was Leeson able to deceive everyone around him? How was he able to post profits on his 'switching' activity when he was actually losing? How was he able to show a flat book when he was taking huge long positions on the Nikkei and short positions on Japanese interest rates? The Board of Banking Supervision (BoBS) of the Bank of England which conducted an investigation into the collapse of Barings believes that "the vehicle used to effect this deception was the cross trade."1 A cross trade is a transaction executed on the floor of an Exchange by just one Member who is both buyer and seller. If a Member has matching buy and sell orders from two different customer accounts for the same contract and at the same price, he is allowed to cross the transaction (execute the deal) by matching both his client accounts. However he can only do this after he has declared the bid and offer price in the pit and no other member has taken it up. Under SIMEX rules, the Member must declare the prices three times. A cross-trade must be executed at market-price. Leeson entered into a significant volume of cross transactions between account '88888' and account '92000' (Barings Securities Japan - Nikkei and JGB Arbitrage), account '98007' (Barings London - JGB Arbitrage) and account '98008' (Barings London - Euroyen Arbitrage).

After executing these cross-trades, Leeson would instruct the settlements staff to break down the total number of contracts into several different trades, and to change the trade prices thereon to cause profits to be credited to 'switching' accounts referred to above and losses to be charged to account '88888'. Thus while the cross trades on the Exchange appeared on the face of it to be genuine and within the rules of the Exchange, the books and records of BFS, maintained in the Contac system, a settlement system used extensively by SIMEX members, reflected pairs of transactions adding up to the same number of lots at prices bearing no relation to those executed on the floor. Alternatively, Leeson would enter into cross trades of smaller size than the above but when these were entered into the Contac system he would arrange for the price to be amended, again enabling profit to be credited to the 'switching' account and losses to be charged to account '88888'.

Table 10.3 below is an example of how Leeson manipulated his books to show a profit on Baring's switching activity.

Table 10.3 No. of contracts in account '88888'2 Price per SIMEX Average Price per CONTACT Value per SIMEX
JPY millions
Value per CONTACT
JPY millions
to '92000'
JPY millions
Buy Sell
20 January 6984 18950 19019 66173 66413 240
23 January 3000 17810 18815 26715 28223 1508
23 January 8082 17810 18147 (71970) (73332) (1362)
25 January 10047 18220 18318 91528 92020 492
26 January 16276 18210 18378 148193 149560 1367
1. This table is Figure 5.2 of Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Common, Her Majesty's Stationery Office, 1995.
2. This column represents the size of Nikkei 225 cross-trades traded on the floor of SIMEX for the dates shown, with the other side being in account '92000'.

The BoBS report notes "In each instance, the entries in the Contac system reflected a number of spurious contract amounts at prices different to those transacted on the floor, reconciling to the total lot size originally traded. This had the effect of giving the impression from a review of the reported trades in account '92000&' that these had taken place at different times during the day. This was necessary to deceive Barings Securities Japan into believing the reported profitability in account '92000' was a result of authorised arbitrage activity. The effect of this manipulation was to inflate reported profits in account '92000&' at the expense of account '88888', which was also incurring substantial losses from the unauthorised trading positions taken by Leeson. In addition to crossing trades on SIMEX between account '88888&' and the switching accounts, Leeson also entered fictitious trades between these accounts which were never crossed on the floor of the Exchange. The effect of these [off-market trades, which were not permitted by SIMEX], was again to credit the 'switching' accounts with profits whilst charging account '88888' with losses."

The bottom line of all these cross-trades was that Barings was counterparty to many of its own trades. Leeson bought from one hand and sold to the other, and in so doing did not lay off any of the firm's market risk. Barings was thus not arbitraging between SIMEX and the Japanese exchanges but taking open (and very substantial) positions, which were buried in account '88888'. It was the profit and loss statement of this account which correctly represented the revenue earned (or not earned) by Leeson. Details of this account were never transmitted to the treasury or risk control offices in London, an omission which ultimately had catastrophic consequences for Barings shareholders and bondholders.

Figure 10.32, below, shows the number of cross-trades executed by Leeson. It is the difference between the solid line which represents all the Nikkei trades of account '92000' not crossed into account '88888' and the broken line which reflects the position Leeson reported to Barings management. The figure graphically illustrates the chasm between reported and actual positions. For example, Barings management thought the firm had a 'short' position of 30,112 contracts on SIMEX on 24 February; in fact it was long 21,928 contracts after ignoring the trades crossed with account '88888'.

Figure 10.3 Graph to show the Nikkei Position of Account '92000'. Reproduced by permission from the Report of the Board of Banking Supervision Inquiry into the Circumstances of the Collapse of Barings.


1, 2) Report of the Banking Supervision Inquiry into the Circumstances of the Collapse of Barings, Ordered by the House of Commons, July 1995, Her Majesty's Stationery Office, London

See also: Leverage, Maturity, Risk Management, Variation Margin


Case Studies * Not Just One Man - Barings